The Other Amazon

Besides being the number one e-retailer, Amazon (NASDAQ:AMZN) is also a growing provider of Internet services. Through its Amazon Web Services (AWS), the company is trying to create a company that will be a hybrid of technology and retailing.

Details on AWS

Founded in 2006, AWS provides cloud services to a number of companies and government agencies like National Institutes of Health.

Amazon does not disclose the exact revenue figures for AWS nor does it provide any details on its margins. AWS is included in the "others" category that reported revenue of $798 million in the recent first quarter and $2.5 billion in FY2012. Many analysts are of the view that AWS accounts for a large portion of this category and is the main driver of growth in the category. This category has increased by 59% both in the first quarter and in FY12. This compares to the 22% increase in Amazon's consolidated revenue in the first quarter and 27% in FY12.

The company also doesn't mention the margins derived from the business but many analysts view it as the key reason for growth in its gross margins. It is estimated that gross margin from AWS is as high as 100% because the related costs are covered under the company's consolidated technology and content expense line. The company at the recent quarter has mentioned that the increase in its gross margins i.e. increase of 260bps, is attributed to third-party digital content sales, Amazon Prime memberships and its AWS business.

This business is relatively small as compared to Amazon's retail business but the company has sped up the rate of its web services release, launching 158 new services in 2012 as compared to 81 in 2011. Initially the company only catered to start-ups and small businesses but has now become a significant force in the market for corporate IT services. It has bagged a number of customers ranging from Netflix (NASDAQ:NFLX) to Pfizer (NYSE:PFE) and Johnson & Johnson (NYSE:JNJ). Further, it recently introduced Redshift which is a new data warehousing solution aimed at taking market share from the more expensive solutions provided by Hewlett-Packard's (NYSE:HPQ) Vertica and Oracle Corporation (NYSE:ORCL).

There are a number of alternatives to AWS with a number of technical and other advantages and some are even available at discounts. But right now Amazon is the one that is setting terms with its aggressive pricing and new products. The company has been able to cut its product prices 31 times since its launch in 2006 including 7 times in 2012. This has been possible as the company is able to leverage on its infrastructure due to increased sales.

Future growth

In November 2012, at the AWS summit in San Francisco, Andy Jassy, Vice President of AWS, gave an overview of how large AWS has grown in the market of cloud-based data storage. He mentioned that its current server capacity - "would have handled all of Amazon globally back in 2003, when we were a $5.2 billion business with 7,800 employees."

Going forward AWS has a number of growth opportunities as it takes a concerted approach to expand to larger enterprises. AWS' broadening platform along with its well-known interface (dominant among many developers) will help in a smoother adoption by many large enterprises. Further, it also has opportunities in emerging markets as many companies may ignore the traditional IT operators and go for cloud services.

Research analysts have a divided view on the future growth prospects of AWS. Some believe that AWS is just the sale of Amazon's excess compute and storage capacity as a way to recoup its expenses. Hence, it is largely dependent on the parent's success and if Amazon would fall, so would AWS. On the other hand, many analysts are of the view that AWS has the potential to be viable on a standalone basis.

Supporting the later view, Macquarie Capital has issued a report contending that AWS is not only profitable but can be currently valued as a $19 billion business on a standalone basis. This is based on Macquarie estimates that the overall cloud market will reach $71 billion in 2015 and AWS' share is pegged at $38 billion. Hence using a 5x multiple of Macquarie's 2013 estimated AWS revenue of $3.8 billion, its current value would be $19 billion.

Another analyst supporting the view is Robert W Baird, which released a report last month. It described AWS as a business that will "catalyze a substantial and accelerating shift in the technology landscape". According to the report, for every dollar spent on AWS, $3 to $4 is not spent on traditional IT. Hence if AWS reaches $10 billion revenues by 2016, it would mean $30 billion to $40 billion lost from the traditional IT segment.

Rackspace is one of Amazon's strongest competitors. The company's OpenStack, a public cloud that allows interaction between many different cloud networks, is providing a strong competition to AWS. However, the company's stock has taken a beating in the year to date period, declining almost 28%. This is largely due to its weak results and negative response to its February announcement to reduce prices in order to compete with Amazon. The company has missed analyst expectations in the last two quarters. Further, at the recent first quarter earnings Chief Financial Officer Karl Pichler acknowledged that it has seen a slowdown and will now "focus on restoring its growth trajectory". The company's above acknowledgment and weak first quarter results only further corroborates the view of many research analysts who recently downgraded its rating citing that it may not be able to maintain its 25% growth rate. Further the company also did not provide any guidance on its revenue or earnings target for 2013 and surprisingly lowered its capital expenditure, an unusual action, as these companies require huge investments for infrastructure developments.

Recently, Microsoft announced that Azure has surpassed the $1 billion revenue mark. According to Forrester Research, Azure's market share is 20% as compared to AWS' 71% but Microsoft is trying hard to increase its sales from Azure (Source: Bloomberg). As Microsoft continues to be bogged down by weaker sales of its Windows software, it is depending on Azure to bolster its growth. Azure subscriptions have increased 48% in the last six months. Further, it has posted sales growth of at least 10% in the last nine consecutive quarters. However, it is facing tough competition, as many users are unwilling to make a switch from AWS as they have been using its products for long. In response, Microsoft has been rolling out new cloud services designed to compete against AWS and has even decided to match its prices.

Conclusion

One cannot ignore the most important fact that all the above estimates regarding AWS' future growth is based on numbers that Amazon does not divulge. It is still a mystery whether AWS is an independent business unit and whether it relies on the parent's cash flows. But it is certain that Amazon is focused on developing this low-price, high-volume business as evident in its increased capital investments. In its recent earnings call, CFO Tom Szkutak has mentioned that it is making - "additional investments in support of continued business growth, including Amazon Web Services".

However, only time will tell whether Amazon's retail business can alone finance its retail and AWS expansion plans and whether at some point in the future AWS will be reported on a standalone basis.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: StockRiters is a team of analysts. This article was written by Audrey Echa - B.Com, Chartered Accountant (India), work experience at Merrill Lynch, Goldman Sachs, HSBC etc - one of our analysts, and edited by Shas, StockRiters' Editor-in-Chief. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.

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